(Ab)Use of Leverage, Short Sales, and Options by Mutual Funds
54 Pages Posted: 22 Mar 2017 Last revised: 23 Jan 2018
Date Written: January 20, 2018
We study the use of leverage, short sales, and options by equity mutual funds and find that their use is associated with poor performance. Our results suggest that moral hazard and agency costs contribute to this underperformance. Consistent with moral hazard, funds that use these complex instruments hold high-beta equity positions that are associated with low risk-adjusted returns. They then attempt to use the instruments to reduce the risk of their portfolios, but in an imperfect and costly way. We also find evidence that funds use complex instruments to manipulate risk following poor performance. The negative outcomes associated with complex instrument use dissipate in funds that are well-monitored, well-incentivized, transparent, and invest in low-beta stocks. Our results suggest that investors are better off choosing simplicity over complexity.
Keywords: mutual funds, leverage, short sales, options, complex instruments, fees, performance, risk
JEL Classification: G11, G23
Suggested Citation: Suggested Citation